Rising dollar could hurt earnings in short term

After a drop last autumn, the U.S. dollar has climbed 5 percent against other currencies over the past two months, reaching the highest level since August.

The main reason is the U.S. economy. Although growth is still weak, the outlook for the U.S. is better than elsewhere in the developed world. Europe is stuck in a recession and struggling to control its debt. Japan is trying to push down the value of the yen to boost exports and end deflation.

A strong dollar helps Americans by making imports cheaper and keeping inflation low, but it can hurt U.S. companies two ways. Their goods become more expensive for overseas customers, and the profits on sales abroad are worth less when converted from a foreign currency to dollars.

The impact of the dollar's appreciation is starting to show up in earnings reports. The insurer Aflac, which does much of its business in Japan, says its earnings were hurt as the yen fell against the U.S. currency. Procter & Gamble, which makes Gillette razors and Crest toothpaste, said the stronger dollar was holding back its sales growth overseas.

Many analysts predict that the dollar will continue to rise. Here's a look at what a stronger dollar means for investors.

TOUGH FOR TECHNOLOGY COMPANIES AND MATERIALS MAKERS

A rising dollar could spell trouble for U.S. companies that make software and consumer products, as well as companies that make basic materials like aluminum.

The tech industry relies heavily on foreign sales for growth. About 56 percent of its revenue comes from outside the U.S., according to research by RBC Capital Markets. As the dollar strengthens, U.S. goods become more expensive overseas, discouraging buyers.

Investors worry that could slow business — and profits. As a result, technology companies are tied with materials makers as the worst industry in the S&P 500 this year, rising just 4.2 percent, compared with 10 percent for the overall market. Business software giant Oracle said in its most recent earnings report, on March 20, that the rising dollar lowered its earnings by about two percent.

The materials industry, which includes Dow Chemical and miner Cliffs Natural Resources, also gets more than half of its sales overseas.

"We would be wary of sectors that derive a lot of their sales overseas, given that fact that we expect the dollar's strength to remain," says Kristen Scarpa, an investment strategist at Barclays Wealth and Investment Management.

COMMODITY CONCERNS

When the dollar appreciates, it makes commodities like oil and metals — which are priced only in dollars — more expensive for customers who buy them with other currencies like the euro and the yen.

That can weaken demand for commodities, hurting the profits of the companies that produce them, like oil producers Exxon Mobil, Chevron and metals companies like the aluminum producer Alcoa.

The S&P mining and metals index, which includes Alcoa and the gold miner Newmont Mining, has fallen 6.6 percent this year. Energy is the weakest industry in the S&P 500 in the past month, up less than 2 percent, versus 4 percent for the S&P 500.

RETREAT FROM EMERGING MARKETS

For investors putting their money to work overseas, the stronger dollar presents a different problem.

The MSCI emerging markets index, a benchmark of stocks in developing countries, including Brazil, South Korea and China, is down 1 percent this year before accounting for changes in currency rates. When measured in dollar terms, the loss widens to 2.1 percent. That's because the currencies of those countries have fallen in value against the dollar.

HOME SWEET HOME

If you're worried about the dollar rising, telecommunications companies like AT&T and utility companies like Duke Energy offer a haven.

These companies are shielded from the impact of a stronger dollar because almost all of their sales are in the U.S.

Utility stocks have risen 5.1 percent in the past month, the second-best performing industry group in the S&P 500.

BIGGER GAINS FOR THE SMALL

Smaller companies make fewer sales overseas than large multinationals, so they aren't affected as much by the strengthening dollar, says Phil Orlando, chief equity strategist at Federated Investors.

The Russell 2000 Index, which tracks small companies, has risen 12 percent since the start of the year, outperforming the 10 percent advance for the S&P 500.

Gains in small companies have been led by health care stocks like Keryx Biopharmaceuticals, which has risen 170 percent since the start of the year, and Coronado Biosciences, which is up 116 percent.

WIDER BENEFITS

A gradually strengthening dollar is good for the stock market as a whole, and will outweigh the initial impact on earnings, says David Bianco, the head of U.S. equity strategy for Deutsche Bank.

As the dollar rises, it lowers the cost of imports, holding down inflation. That, in turn, makes it easier for the Federal Reserve to keep interest rates low.

Because investors love the stability that low interest rates and tame inflation bring, they will be more willing to own stocks. That will push up stock prices even if corporate earnings don't increase, Bianco says.

Deutsche Bank analysts forecast that the dollar will strengthen to $1.20 against the euro by the end of the year, or about 7 percent, from its current level of $1.29. By the end of next year, they see the dollar strengthening to $1.15 against the euro.

"I'd welcome a stronger dollar," Bianco says. "It contains the risk of any surge in interest rates, or inflation risk."